How do you access the value that is locked into your home? When you make payments toward your mortgage to pay down the principal amount you owe, it creates a difference between the value of the home and the debt that you manage. Another option is to have the value of your property increase over time, going beyond what you initially paid to manage your real estate. This is your equity.
Equity has value, but it is not the kind that you can spend. You must work with a lender who will give you liquid capital, which is cash, in exchange for the collateral that your property provides. That means you are essentially taking out a second mortgage on your home when you choose to pursue a home equity loan or a line of credit (HELOC). By tying the value of what you’ve built up over time to either lending product, you can get a decent rate because it acts as a secured loan.
Then you become responsible for making payments toward either product each month based on the terms agreed upon with your lender. If you fail to live up to that responsibility for any reason, then it could result in a loss of ownership.
Because you are managing a tangible asset, there are some specific pros and cons of a home equity loan vs. a line of credit that you will want to review before accessing the equity in your property.
List of the Pros of a Home Equity Loan vs a Line of Credit
1. Home equity loans give you all of the cash right away.
When you choose a home equity loan for your property, then you get a surge of cash right away that you can use for any reason. Most experts agree that these funds should go back into your property to increase its value, but some homeowners use it to pay for college, clear away high-interest debt, or take care of emergency expenses. You would then repay the loan according to the terms and conditions agreed upon with the lender.
A line of credit works more like a secured credit card where your home equity acts as the deposit. You can draw as much as you want up to your limit, but then you are responsible to repay whatever amount you take. There is usually a draw period (of up to 10 years), and then the line of credit freezes to become what is essential a home equity loan then.
2. You will usually get a better interest rate with a home equity loan.
A home equity loan gives you a fixed interest rate that will typically be lower than what a line of credit will provide when you wish to unlock the value of your property. During Q1 2019, you could access a fixed APR with this lending product of 4.89% if you took out a second-position home equity installment loan of $50,000 to $250,000 in the United States. That assumes that your loan-to-value ratio was 70% or less.
If you went with a line of credit for your home equity instead, then your APR would be closer to 6%, and it could also be variable. It would also be a second position lending product as well. That’s still better than an unsecured credit card or a signature-based line of credit from a local bank or credit union, but it also comes with the creditor risk tied to your home.
3. Home equity loans provide you with a fixed payment schedule.
Another advantage to consider with a home equity loan is the fact that you will know the exact repayment schedule for this lending product from the moment you accept the terms. That can make it a lot easier to budget this expense because it becomes a predictable component of your finances.
A home equity line of credit does not always provide the same experience, especially if you are within the draw period of this lending product. The monthly amount you owe depends on how much of your equity that you decide to use. Many HELOCs come with a variable interest rate during this time as well, which means you could find yourself spending more each month to manage the debt.
4. You don’t need the same levels of income stability with a home equity loan.
A home equity loan ties directly to your property in a second position as collateral, so there is typically a higher approval rate for those who have unpredictable or unusual streams of income. If you work as a self-employed individual, own a business, operate as a freelancer, or perform jobs as an independent contractor, then it is usually easier to use a loan instead of a HELOC with your property.
A home equity line of credit likes to see a strong credit score, usually a FICO above 740, and up to 7 years of stable employment and growing wealth before approval. You can prove these items with an alternative income through tax returns and receipts too, but the process tends to be lengthy.
5. You have fewer tax complications with a home equity loan.
After the passage of the Tax Cuts and Jobs Act, you can no longer deduct the interest on a home equity loan or a line of credit through the 2025 tax year if it involves equity indebtedness. That means if you secure the lending product using your home and then use the funds to pay off a credit card or buy a new car, then you typically could not make an interest claim. This rule also applies to a line of credit.
The difference here is that a home equity loan is easier to produce income because of how it is structured, which allows you to still deduct the interest on your taxes. If you have a net investment income of $5,000 and interest paid of $7,000, you’d get to make a $5k claim and carry forward the remainder to the next tax year.
6. There is more control over spending with a home equity loan.
Homeowners that have access to a line of credit for their equity must maintain a high level of discipline with their spending habits. Because they can draw on the proceeds at any time they feel it is necessary, the creation of extra payments could be problematic if there is a change to your financial situation. It is not unusual to have monthly payments that are $300-$500 more than anticipated after tapping out the credit.
A home equity loan works better for those with spending habit concerns because everything becomes available right away. You know what your repayment responsibilities will be, how much you can access, and what you intended to do with the money.
7. A home equity loan won’t charge you if you don’t use the money right away.
When you choose a home equity loan, then you can do what you want with those funds. Even if you don’t spend the money for more than a year, the only debt responsibility you have is the monthly payment that takes care of your interest responsibilities while paying down the principal of the loan.
A home equity line of credit will charge you the maintenance fees each year whether you decide to take money from a draw or not. If you are unsure of how you’ll spend the money that is locked In your property right now, then a loan or an unsecured credit card might be a better option because each will limit your long-term costs.
8. Home equity loans give you a fixed interest rate.
The primary problem that homeowners have with a home equity line of credit is that the interest rate can be variable to an extreme in some years. Some HELOC options make changes to this rate every month, which means you never know how much your payment will be. Although it could go down and you could owe less, the trend since 2008 has been a rise in interest rates, so you would pay more. Some states cap the interest rate at 18% for this lending product to protect consumers from this practice.
A home equity loan gives you stability because you have a fixed interest rate at all times. This advantage might be a problem if the economy stalls and rates fall, but it will protect you from any increases that might occur.
9. You can use the money from a home equity loan for almost anything.
One of the benefits that you receive with a home equity loan is that the cash you receive is useful for almost any need. That can be a problem if you are prone to making risky financial decisions, but it could also be a way to get enough capital to start a business, fund an addition to your home, cover the tuition expenses for your children, or similar needs. Just remember that if you use it for indebtedness that any tax advantage you might receive with this product will disappear.
Some people even use a home equity loan as a way to fund their retirement, although there are other options, like a reverse mortgage, which might be a better option to choose.
10. You don’t need to worry about a lender canceling your credit.
Because you receive the entire proceeds of the home equity loan once you receive approval for it, all of the cash that you need comes to you in one lump sum. That’s why you can choose to do whatever you want with it at any time. You get to control the terms of access when there is a need to have some extra cash lying around.
A home equity line of credit is a little different. Although a HELOC does provide more flexibility over time, the lender has more options that could impact you in adverse ways as well. They could choose to freeze it to prevent access at a time when you need it the most. There is also the option to cancel the credit line if they feel like you become too much of a risk, and then you would still be liable for whatever debt you drew upon up until that time.
List of the Cons of a Home Equity Loan vs a Line of Credit
1. You can lose your property through the foreclosure process if you fail to repay your debt.
To be clear, both a home equity loan and a HELOC will be a second-position responsibility if you decide to unlock the equity of your home. That means there is a direct tie between the creditor and your property. If you fail to make the agreed-upon payments for any reason, then your lender can move to begin foreclosure proceedings. This disadvantage can occur even though you keep up with the payments on your first mortgage.
That is why an unsecured credit card is sometimes a better option, despite the higher interest rate you will pay. If you are unsure of what life might bring your way, then choosing a lending product that doesn’t put your home at risk sometimes makes more sense.
2. The closing costs of a home equity loan are more expensive than a line of credit.
Most lenders today will provide a home equity line of credit for a minimal fee, and many of them are moving to no-fee lending products if you agree to keep using the product over a specific amount of time (usually 5+ years). You will find several lenders who provide a HELOC option for less than $750 in the United States, and some local providers can be as low as $100 – even on a $100,000 loan.
If you prefer a home equity loan, then you can expect to pay somewhere between 2% to 5% of the value of the lending product in closing costs. Let’s say that you have a $100,000 loan you wish to access – at 3% for the closing costs, you will pay $3,000. Although you can often roll that cost into the loan, it is still a significant difference to consider.
3. You are stuck with the full amount if you choose a home equity loan.If you decide to pursue a home equity loan, then your lender will give you the full amount of what you have agreed upon with your application. There is no other option. Then you will begin to make your monthly payments immediately, although some providers might offer a 30- to 90-day grace period.
When you opt for a home equity line of credit instead, then you get to be in control of how much you take out. If you only need $20,000 to manage a project instead of $100,000, then you can use that instead, making your monthly payments lower than they would be otherwise.
4. Some home equity lines of credit offer a better interest rate.
If you have a strong credit profile and have 7+ years professional experience in the same job or with the same employer, then a home equity line of credit might be a better way to save some money. When looking at a moderate-risk situation for homeowners in Q1 2019, a HELOC was still averaging around 6% per customer, but the home equity loan was closer to 9%.
Even when you include the variability when accessing a line of credit compared with a loan, the savings from interest alone could total several thousand dollars. You may want to speak with your lender about both options to see which way could save you the most money.
5. There are fewer long-term fees to worry about with a home equity loan.
When you choose to unlock the value of your real estate with a home equity loan, then all of the fees that you encounter with the product are typically there at origination. You’ll pay a lump sum that can sometimes be rolled into the loan itself so that your out-of-pocket costs are minimal. Then you begin to repay using the monthly payment amount agreed upon in the terms of the lending product.
A home equity line of credit usually requires you to pay ongoing maintenance fees that can eat away at the value you receive. Most banks charge at least $75 per year as an administrative cost to maintain the HELOC, with fees sometimes as high as $250. You might also experience higher charges if you do not access the full amount of your equity for some reason.
6. It is easier to go underwater with a home equity loan vs. a HELOC.
When you owe more on your property than its overall value, then that means you are “underwater” on your home. Some lenders refer to this situation as being “upside down.” A loan or a line of credit tied to your equity can put you into this situation. It is easier for a home equity loan to go underwater because you receive the entire proceeds from the lending product after approval.
If you suspect that home values might drop for some reason, then a line of credit is the better option because you can limit how much you draw. When the market rises and there is less risk, then you can take out the full amount and essentially convert it to a home equity loan anyway.
7. A home equity loan could be for more than the net worth of your house.
If you receive an offer for a home equity loan which is more than the overall net worth of your property, then you are fast-tracking your finances toward bankruptcy. Although this disadvantage was seen most often during the subprime mortgage lending years, there is a possibility that someone might offer you more than what the LTV ratio would indicate. If you are thinking about using this lending product to pay of a loan and you face this situation, then you should look for other ways to save money first.
8. You are creating another significant debt that you must repay.
Although a home equity loan does give you some value for this asset, it is not free money that you get to receive. You are creating another significant debt that will require a monthly payment that is due with your mortgage each month. If you really need debt-free cash fast, then a better option might be to sell your current property and look for ways to start downsizing. This move might have tax implications for you as well, but it won’t create another debt that you need to manage.
If you prefer flexibility, then a home equity line of credit is the better option here. Although your lender could freeze or cancel it before you have the chance to use it, you’ll be the one dictating home much debt you’re willing to take on when you need some extra cash.
Conclusion of the Home Equity Loan vs. Line of Credit Pros and Cons
A home equity loan or a line of credit are both useful lending tools to consider when you are ready to unlock the value of your home. Although there are risks to think about with either option, as there are with any other debt, you will find that some distinctive rewards are available when using these products wisely.
Taking the money from your equity and reinvesting it into your property can increase its value further, which allows you to access additional value in the future if needed.
The pros and cons of a home equity loan vs. a line of credit are important to consider if you are in a position right now where you must turn locked value into liquid capital. Work with your preferred lender to find the terms that you can manage, and then don’t forget to shop around to see if you can achieve a better rate. You are not required to work with your mortgage originator to gain access to the cash that you need or want.
About the Author of this Article
Crystal Ayres is a seasoned writer, who has been serving as our editor-in-chief for the last five years. She is a proud veteran, wife and mother. Vittana's goal is to publish high quality content on some of the biggest issues that our world faces. If you would like to contact Crystal, then go here to send her a message.